Negative amortization arises when the mortgage payment is smaller than the interest
due and that causes your loan balance to increase rather than decrease.
Your mortgage payment has two parts: an interest payment covering the interest
due for that month, and a principal payment. The principal payment reduces the
loan balance and is called "amortization."
For example, the monthly mortgage payment on a 30-year fixed-rate loan of $100,000
at 6% is about $600. In the first month, the interest due the lender is $500,
leaving $100 for amortization. The balance at the end of month one would be
$99,900.
The $600 payment is a "fully amortizing" payment. If you continue
to pay that amount every month during the period remaining to term and the interest
rate does not change, the loan will be paid off at term.
A $550 payment would be partially amortizing, leaving a balance at the end
of the loan’s term. A $500 payment would just cover the interest – there would
be no amortization.
If your payment is only $400, it would fall short of the interest due by $100
and the loan balance would rise to $100,100. In effect, the lender makes an
additional loan of $100, which is added to the amount you already owe. This
rise in the loan balance is called negative amortization.
Negative amortization can only arise on ARMs with one or more of the following
features:
- The initial payment does not cover the interest due, as in the example.
The purpose of such a feature is to increase affordability.
- The interest rate adjusts more frequently than the monthly payment. The
purpose of this feature is to avoid frequent changes in your monthly payment.
- Changes in the monthly payment are capped, usually at 7.5%. The purpose
is to avoid large changes in the payment.
But these borrower-friendly features have a downside. If interest rates rise
persistently, the equity in your house will decline rather than rise unless
the negative amortization is offset by house appreciation. In addition, negative
amortization must be repaid, which means that your payment is going to rise
in the future. The larger the negative amortization, the greater will be the
increase in the future payments that will be required to amortize the loan in
full.
"When I expressed concern about negative amortization, my loan officer
said not to worry, that my ARM limits the amount to 25% of the original balance.
Is he right?"
He is correct that negative amortization is limited, but the implication that
the limit protects you is misleading, at best. The limit is designed to protect
the lender, not you.
If you ever reach the limit, the lender immediately raises the mortgage payment
to the fully amortizing level, regardless of how large an increase that might
be. A negative amortization cap overrides a payment adjustment cap.
The negative amortization cap would be reached only if interest rates increase
persistently over a long period.
In
Is a 3.95% ARM a Good Deal?, I examine what would happen to the payment
and to the loan balance on a negative amortization ARM if interest rates rose
by 1% a year for 5 consecutive years. This ARM had monthly rate adjustments,
annual payment adjustments capped at 7.5%, and an initial payment below the
interest payment.
The payment on this ARM would rise by 7.5% in months 13, 25, 37, 49, 61 and
73. But in month 82, two months prior to the next scheduled payment adjustment,
the loan balance would hit 125% of the original balance. At that point, the
payment would jump by 77%.
I concluded that while this was an unlikely event, it was not impossible.
ARMs that allow negative amortization can increase home affordability, and
may also offer lower interest costs than other mortgages, provided that interest
rates don’t rise persistently. As with most everything else in finance, the
benefits come packaged with risk.
